Taxes - Income Tax vs. Consumption Tax

I’ve always had an internal debate about the issue of Consumption Tax and whether it is ultimately more fair than the income tax. Looking at the issue from a general perspective, consumption tax makes more sense. You pay for what you consume. This proportionally taxes the rich since they theoretically buy more expensive goods, and rewards savings, as people will think twice about spending money on frivilous items.

Looking more into the issue, however, there are many other facets to this debate as described in the article below. I was not really thinking about the transition issues but obviously those issues would be great, as I’d imagine any major shift in tax policy would have. The middle and the lower income classes would be the ones mostly hurt by this policy, an issue I did not really think all the way through. With a pure consumption tax, all the deductions, tax breaks, interest write-downs would be eliminated, in a sense making those that didn’t have to pay taxes under the current system pay taxes as they consume. This would either further deteriorate the economic welfare of the poor or force them to live in sub-standard conditions, trying to save while foregoing basic consuming. The other issue is how much would the actual consumption tax have to be to replace current income tax revenue. I think the article estimates that the tax would have to be about 60% - impressive. And this rate would be applied to all consumables including health care, housing, etc.

The authors did mention that there are hybrid tax plans that can negate the negative effects of consumption tax. I’d be really interested in seeing what those tax theories are because I still think that in theory, consumption tax makes sense.

http://www.brookings.edu/interviews/2005/0303taxes_gale.aspx

The Pros and Cons of a Consumption Tax

Ray Suarez: The president’s advisory panel on tax reform met for the second time today, this time seeking the input of Fed Chairman Alan Greenspan. Greenspan said the tax code needed to be simplified and suggested one idea worth considering was implementing some kind of consumption tax. It’s a broad idea that’s also gained favor among some policymakers in Washington.

For a closer look at consumption taxes, what they are and how they might work, I’m joined by two men who study these issues closely. William Gale is a senior fellow at the Brookings Institution. And Len Burman is a senior fellow at the Urban Institute. They’re the co-directors of the institutes’ Joint Tax Policy Center, which is non-partisan.

And William Gale, why don’t you get us started by just explaining what a consumption tax is, who pays it, what does it tax?

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William Gale: What does it tax? A consumption tax essentially taxes people when they spend money. And the income tax you’re fundamentally taxed when you earn money or when you get interest, dividends, capital gains, and so on. And a consumption tax that wouldn’t happen, you would be taxed essentially when you actually spent the money at the store.

Now one way to think about a consumption tax relative to the existing income tax is suppose we had our current system, but we made IRA contribution limits infinity, so you could put as much as us wanted into an IRA and you could take it out for any reason, all right. That to the first order of approximation would be a consumption tax.

Ray Suarez: Okay, Len Burman, first of all, do you buy that definition?

Len Burman: Well, yes, quite close. One thing that Bill left out was that under a consumption tax you’d actually pay tax on money you borrowed at the same time. So you wouldn’t be taxed on your interest, dividends and capital gains, but you wouldn’t be allowed a deduction for interest expense.

And that’s actually an important distinction. We’re actually sort of moving toward that system Bill is talking about, but without the limit on the interest deductions you could actually create a situation where it’s a recipe for unlimited tax shelters, which is not what I think any of the tax reform advocates would like.

Ray Suarez: And for people who are sitting with receipts on week nights and pieces of paper and an adding machine trying to figure out as April 15 looms, this would mean filing a tax return would become a very different business from what it is today.

Len Burman: Yeah, it depends on how you implemented the consumption tax. If you started with our income tax and then said look you’re going to have a deduction for all of your interest dividends, capital gains and you have to include in the tax base the interest expense, it actually could make it more complicated.

Some other variants are you could have a consumption tax where you just pay tax on your spending, a value added tax which they use in Europe and Japan; it’s a variant of a sales tax and it’s actually transparent to individuals, you don’t have to, individuals don have to file tax returns to pay that tax.

But an important distinction is that in Europe, the value added tax is a supplement to the income tax; it’s not a replacement, so people still have to file income tax returns every year.

Ray Suarez: So William Gale, anybody who’s paying sales tax in the 40 states that have it are already pretty familiar with the concept? Is it as simple as just a new sales tax?

William Gale: Not really. The sales taxes that exist in the states may serve the purposes of the states quite well, but they are very poor models for a federal consumption tax. The state sales taxes omit all sorts of spending, typically health, food is often omitted, a variety of other things, housing. Health, food and housing is half of all consumption.

So, if we want to have a consumption tax at the federal level we need to tax a very broad base of consumption, almost all consumption. So, if anything, the state, the experience that the states have with the sales tax tell us that it’s very hard to actually implement a clean simple broad based consumption tax.

Ray Suarez: Well, let’s talk a little about implementation, Len Burman. Alan Greenspan said today getting from the current tax system to a consumption tax raises a challenging set of transition issues. Like what?

Len Burman: Well, if you just say scrap the income tax and replace it with a sales tax or a value added tax, then it would be a huge tax increase on old people, old people who are paying tax on their income as they’re earning it, thinking that when they got to retirement they could spend money and they’d be paying a dollar for everything they bought.

If you replace, Bill actually did some estimates that if you replaced all of our taxes with the sales tax, the sales tax rate would be something like 60 percent, so you could just imagine getting into retirement and finding out the price of all the goods you’re buying is now 60 percent higher than it was the day before. That would be like a 60 percent tax on all of the money that you had saved up over the course of your life. And there are other transition issues too, like the way it affects businesses.

There are variants on the consumption tax, but basically nobody has figured out how to deal with the transition issues without tremendous cost to the Treasury. You can basically say you could have transition rules that would try to protect old people, that would try to protect businesses that have made investments under the old rules that could be harmed under the new system, it would be tremendously expensive.

And in fact, when economists look at the transition from an income tax to consumption tax, most of the gain to productivity comes from this tax on old savings, this tax on old capital, and the reason that Congress got excited about this, because it’s a tax that can’t be avoided, it doesn’t alter people’s behavior. But that’s also the same reason why people think it’s so unfair, you can’t get out of it, and it’s basically changing the rules after you’ve been making decisions over a whole life.

Ray Suarez: Well, the president asked his new tax commission to create a revenue neutral model for changing the tax code, meaning that he didn’t want the federal government to collect more taxes, about the same.

But underneath that umbrella, would people be paying roughly the same amount of tax if we move to a consumption tax? Or are we assuming that different people would pay more or less than they used to pay?

William Gale: In theory you can set up a consumption tax to have any group of households pay it. In the real world, every consumption tax out there is going to hit low and middle income households to a greater extent than the income tax does.

Ray Suarez: Why?

William Gale: For two reasons: One is that, well, the main reason is that low and middle income households consume more of their income than high income households do. Another way of saying that is high income households save more of their income than low income households do.

So if you move the tax from income to consumption, you’re raising the relative burden on low savers, which are low and moderate income households, so almost any revenue neutral shift from the income tax to a consumption tax will be regressive in that manner. There are ways, there are conceptual ways to do it that doesn’t add burdens to low and middle income households, but I don’t think that they would actually happen.

Ray Suarez: Well, right now a lot of low income people pay no federal income tax, but they do buy things. Does that mean that they’re almost inevitably going to pay a consumption tax?

William Gale: That’s a very good example. A family of four doesn’t pay any federal income tax until their income is in the 20s or 30s, something like that. If you go to a national sales tax or value added tax, they’d be paying that tax on the very first dollar that they buy.

Now, again, there’s a way to insulate them from that by giving each household cash payments, but no country in the world actually does that. So in the real world, consumption taxes end up being more regressive than income taxes, although Len and I or anyone else could design a consumption tax on paper that wasn’t like that.

Ray Suarez: Len Burman, the Fed chairman said today that one effect of changing the tax code in this way, moving away from income tax to consumption tax, would be to change people’s economic behavior by making it make more sense to save and less sense to spend.

Do we know that that’s really what would happen, and how would it change what makes sense to do in the economy when you have this different kind of tax?

Len Burman: Well, a lot of economists favor a consumption tax because they think it would reduce the penalty on savings. It’s basically savings wouldn’t be taxed, so you have an incentive to do more of it. How much more is, it’s not actually clear; there’s a lot of empirical evidence, research evidence, to suggest that there wouldn’t be a huge increase in savings.

There’s also when you get outside of the economist models, there’s a concern that if we switch, the current system we have now encourages a lot kinds of savings, you get a special break if you put money into a 401-K or your employer puts money in a pension or an IRA.

Under a consumption tax system all savings would be tax-free, it would all be taxed like a 401-K, but the question is if people don’t get the special tax break will they still be putting money into retirement savings and if they don’t, if they just put it in their regular bank account, are they as likely to keep it until retirement, and a lot of people are concerned that in fact without the special tax breaks you could actually end up with less retirement savings and possibly even less savings overall.

The other thing that’s important to note, and the chairman said that there are two things that we needed to do, one is to get people to save more; the other is to get people to work more so as the baby boomers get older they don’t drop out of the labor force. Well, if you’re not taxing savings, inevitably the tax burden has to increase on labor. There’s labor and capital. If capital is exempt, the tax on earnings has to go up. And that means that switching to a consumption tax would penalize working.

So the question is on balance, is the extra incentive to save enough to offset the extra disincentive, the penalty on working? And it’s not clear. In any event it’s not likely to be a very large effect, it’s not going to turbo charge the economy.

Ray Suarez: Well today also the Fed chairman said, William Gale, that there’s likely to be a lot of opposition to this. Who would be, you know, as the two sides line up to do battle, who would be the kind of forces people, institutions who would be against it?

William Gale: Well, it depends on the exact form of the consumption tax. Certainly low and middle income group would be very concerned that their tax burden would go up.

The other groups that would be concerned is anyone who gets a tax break under the current system. Most of these consumption taxes, like a retail sales tax or value added tax or the flat tax, or whatever, talk about cleaning out the tax system, all the special exemptions and deductions and credits and stuff like that. So the charitable sector doesn’t like these things because the charitable contribution disappears.

The entire health sector doesn’t like them because the deductions for health insurance disappear. Businesses, a lot of businesses don’t like tax reform because they lose deductions for payroll taxes and other things. So you have to gore someone’s ox in tax reform, and any time you do that they’re not going to like it.

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19 Responses to “Taxes - Income Tax vs. Consumption Tax”

james

8 November, 2008, 13:21

here is my idea on the Consumption Tax and how the republicans can get there mojo back
do you do the right thing - not smoke, eat right, go to school, not break the law, try to recycle
if you do these things and are poor that a problem for me
ask the average joe and the American people do the go to work and pay taxes to support people
who smoke, don’t eat right (see the movie supersize me - think of the extra heath cost (soon under obama
tax cost),dont go to school,etc
its time for people and American people to pay based on results and stop living beyond there means and having the
average hard working American pay for it
my plan
keep the income tax on people above 125,000 or so - that’s just a number i picked it can be debated and go up or down
then get rid of all other taxes - people and corp
then have a consumption tax on bad things
no tax on non processed food and recycled items, other good things that society can decide on.
tax fast food, smoking the most (i personally would legalize drugs (expect under 21, get caught selling or giving to kids life sentence) and taxes them the highest (call it the new death tax - to pay for there death and heath care cost) and require you to show you have 40 hr a week job to support the habit - because you never going to stop someone from using that wants to)
tax the rest of products a normal rate
instead of having a jail system like today for nonviolent offenders have weekend workcamps - if you steal or have a dui work weekends for a couple years (like 10 to 15) on a farm - that will have end illegals - if the farms and other low paying jobs are done by lawbreakers than the demand for illegals will dry up and stop both it and crime.
industry that provide high paying jobs (like auto that make high mpg cars) that we want here in the USA - don’t tax what they sell or what the buy to make the product
from the taxes from smoking, fast food, other consumption products give a reward for completing school or training for a new job
you the average Joe that does not smoke, eats rights, recycles and goes to school will pay less and have a better life
the coming baby boomers that are going to live the work force is going to mean either we start rewarding for recycle and doing the right things or lower are stardered of living

Consumption Tax sounds very fair but Unreal! Because Sales tax will be jeopardized.

Overtaxed M/C

21 June, 2011, 10:50

First of all any system would be better than the one we have currently and has changed hundreds of times over the years and is still a downer/shaft to the middle class and gold mine to the upper class.
Consumption Tax would put politician on a budget, simply what is collected in 2011 would be the budget for 2012 and so on. In other words politicians bragging about what they brought home for their district (pork barreling) would be no more.
Business Welfare to aid business moving out of the US would be gone.
Farmer Welfare would need to be done away with or put in the budget if it must be needed.

Consumption Tax process will certainly be different than what we have today but would be well worth it. The implementation would simply be done similar to the way we buy car tags; last name alphabetically goes on the Consumption Tax at whatever month you fall within. After one year the Income Tax would be history, an ID card would be issued to aid in the implementation and then used to offset some taxes for the retired, military and certain part of the poor… if there is a will there is a way, America is better than the Europeans or the rest of the world when it comes to figuring this out, surely…
Let’s get-err-done!!

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